Hi Mish.
First of all, this post is exploratory, and the ideas are sort of happening in real time (so hopefully they are somewhat coherent :) ) Please address any assumption or conclusion that you find erroneous.
Is Deflation eminent? - The Financial perspective
The difficulty I have with severe deflation in the U.S. (although I think I previously considered this the most likely scenario), is that it will effectively result in a massive wealth transfer to holders of U.S. debt, which now to a very significant degree includes foreigners (and especially the Asian central banks). I just can't figure how the U.S. financial elites would allow for this, unless there was some underlying quid pro quo that currently escapes me.
Also, I don't believe that massive debt in an economy is inherently deflationary and more than its inherently inflationary. It amounts to a policy choice how this debt burden is eventually lessened/removed. You can go the Weimar Republic route (as a policy choice) or you can go the U.S. in the early 30's/Japan in the early 90's route (as a policy choice), or somewhere in between I suppose.
The "real economy" impact to Deflation
That's the financial end of things, what effect would excess capacity have on the inflation/deflation argument. Is this an inherently deflationary situation? Well, to the degree that many organizations that have excess capacity will (i) have a very difficult time sustaining profitability, and (ii) many employees/households will have a difficult time sustaining employment in this situation, and that (iii) the value of the assets of said organizations will suffer depreciation, and finally, (iv) the debt of said organization go into default, there is certainly a collapse of both wealth and earnings power that ensues.
This in turn could well ripple through the economy as (i) debt obligations owed are, due to falling income, are no longer supportable by firm or household cash flow, and are defaulted by the debtor, and (ii) as debt obligations held (i.e. in the form of bonds for income) of parter and creditor organizations, and employee/households, suffer default, this in turn impairs the balance sheet/future cash flow of the creditor.
Debt Deflation - a Boon to Wall Street financed Cartels?
BTW, having recently read Anthony Sutton's "Wall St. and FDR", I have come to believe that such a scenario (i.e. a Credit Bust) can be made to order for Wall St. since it necessitates a consolidation of monopoly power in the form of cartels who then "manage" output in order to maintain margins. Look for Kerry(?) to emerge as the 21st century's FDR and upon a rupture in the marketplace, while being heavily backed by Wall St. interests, rail against the corruption of Wall St. and promote "New Deal" measures which actually aid industry cartelization.
An "Unconventional" Policy response to Deflationary forces?
But what of the Austrian contention that inflation (and consequently deflation) is first and foremost a monetary phenomenon), and what of Fed Governor Bernanke's contention that the Fed will resort to "unconventional means" to combat deflation in the economy?
What if to maintain a more stable price level, the Fed were to offer $10,000 to every American above the age of 18 on an annual basis to keep some manner of earnings power in the economy. I believe the result of such an initiative could result in really wacky fluctuations in the overall price level, resulting in a huge shift towards relative pricing levels in the economy (i.e. inflation in everything we need, deflation in everything we want).
But it would lessen the burden on debtors(and therefore defacto the U.S. economy generally), at the expense of creditors (i.e. the rest of the world).
A Policy Necessity - Increase Domestic Savings
But no matter, in the U.S., what absolutely must be effected is a policy mechanism which discourages relative consumption and encourages relative savings. And this requires a normalization of the interest rate structure, which will mean relatively high "real" rates of interest for a considerable time.
If this were to transpire, in the initial shock and period of interest rate normalization, even though the initial shock may be dramatically deflationary, "unconventional" policy response could well mean rising nominal interest rates IMO.
Asset Classes of Choice in the event of "Unconventional" Policy Measures
Should this transpire, what would be the asset classes of choice? Well, in this situation it could be a matter of choosing between lesser evils. Put another way, on the back of asset bubble after asset bubble, there may not be "any" asset class that will benefit from this situation.
I think my initial preference would be cash. Followed by short-term government debt. Precious metals would also appear to be a decent holding. The worst holding would have to be stocks or junk-bonds (or emerging market debt IMO). In this situation, longer-term Government debt might turn out OK, or might not. It depends how market rates of interest rise to normalize the interest rate structure, and how much of this normalization of the interest rate structure is achieved by outright deflation, and how much "unconventional" policy response (i.e. printing of money) occurs to offset deflationary tendencies inherent in the economy.
And I haven't discussed currency vulnerability here, which throws another wrench into the equation.
Where could I be wrong
I think the primary vulnerability to the above these is what if the Fed either doesn't, or is unsuccessful, in engaging in "unconventional" policy options (i.e. printing money to offset deflation).
In this case, I think the outright deflationist argument would be pretty much bang on, interest rates will trend to zero, and any form of government debt (long or short term - ignoring currency risk) would be a good bet.
In Summary
That's how I see it. Please be critical of my analysis, as it's pretty formative.
Best regards,
Glenn |
